a primer on externalities

// started 5/4/2014

This is a prelude for my upcoming blog post "ultra liberalism with a dash of state intervention".

Markets are a fantastic tool for the efficient allocation of goods and services. The liberal, capitalist economies of the western world have outpaced any other economic model in the 20th century in terms of wealth creation.

Nevertheless, market forces alone should never be the only regulative power in an economy. if there were such a thing as efficient markets, nearly anything could be regulated by markets alone, sadly reality is a bit more convoluted.

External effects is what economists call outcomes of an activity in an economy which affects reality, however is not represented in the price for that activity. A good example would be the effect that the transportation of goods has on the environment. In a free market, the buyer of the transportation service would only pay for the fuel consumed and the deprecation of the transportation vehicle as well as maybe any services which are involved beyond the pure transportation (onloading, offloading the goods, the meal of the driver, etc.). However, as we all know, any modern truck still emits CO2, one of the main products of combustion, that has adverse effects on the environment (if emitted excessively). In an absolutely free market, it would be very unlikely that a tax on CO2 would have been raised at this point, since the effects (especially the money costing effects ) have only been marginally felt so far. Furthermore the main victims of the increased emission of CO2 are most likely unrelated to the transportation companies (an its related services) - like for example farmers - and hence the increase in CO2 does not negatively affect the transportation companies themselves. Yet we all can agree that an increase in CO2 emissions would be very damaging for our environment and ultimately also for ourselves and hence needs to be supervised, regulated and eventually reduced.

On the other side of the spectrum such a regulatory entity can also drastically over regulate an economy. A good example is the Soviet Union up to the late 80s, where a state approved five year plan set exact goals on the output of the economy. Such plans are especially hindering for an efficient market when the goods which are regulated undergo strong fluctuations in supply and demand. A suitable example is food. It is very ironic that the Soviet leadership made the regulation of food production a key part of their five year plans. The production of food undergoes random cycles, with poor harvests in some years and over production in other years - which mostly lay outside the control of anybody. But also the demand side can drastically vary within even months, changes in eating habits or colder or warmer seasons can have a drastic influence on the demand side - and make any planning a futile effort.

Taking these two simple thought experiments as a starting point, I believe we can conclude that: state run regulation of the economy seldom leads to an efficient economy, unless the demand and supply of a good can be determined with very high accuracy over a very long period of time. no regulation at all will in general lead to an efficient economy, as long as external effects are taken into the price equation via state intervention.

Hence we come to the difficult part of figuring out which external effects should be included into the price (which is many cases not obvious at all) and in which sector of the economy the external effects play such a major role, that any activity (production of goods or services) in a sector must be entirely performed by the country.

A fitting example for the latter sector would be the production of enriched uranium. Enriched uranium is the main component for the assembly of nuclear bombs. The economic effects and the ethical implications of the production of such a device are another discussion, which will not be part of this post. The only thing that matters to us is whether we can assign a reasonable price to enriched uranium and whether there are any external effects we might need to consider. Uranium itself is a rather uncommon element in the crust of the earth and as such we have already a good starting point for calculating our price, because any mining operation involving uranium will most likely require a lot of personnel and equipment, which needs to get paid. Furthermore the process of enriching uranium is fairly complex and only a handful of institutions have mastered the process, so the costs for enrichment might as well outweigh the costs of mining. Nonetheless the enrichment process and any research and development costs which flow into it can be priced more or less easily. Leaving aside the external effects the mining operations will have on the environment, why is it that there is no free market for enriched uranium?

The obvious external effect in this case is the potential threat enriched uranium can have in the wrong hands. If enriched uranium could be purchased like any other good, it would soon end up in the hands of people with malicious intent and pose a threat to the worlds population. Not to say that a nuclear bomb is in itself a powerful bargaining tool and could cause an inefficient allocation of goods, if it were used for, let's say, extorting the national bank. Hence because these external effects are so dominant and far outweigh any other costs involved in the production of enriched uranium (cost of enriching vs. cost of human lives), the economy for uranium enrichment is solely in the hands of the government.

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